There is so much more to personal finance than just understanding the hard numbers. Spending decisions are influenced by a myriad of factors. Some, like habits and personal experience, can change over time. Others, like behavioural biases, are unconscious ways our brain reacts to its environment and financial situations. Whether grocery shopping, house hunting, or setting up a savings account, these biases impact every aspect of our financial instincts.
In the fast lane
When making decisions, your brain has two systems: slow and fast.
The slow brain is conscious, deliberative, rational and energy intensive. The fast brain is intuitive, emotional, and requires much less energy, making decisions in mere milliseconds. Think of it as the difference between parallel parking and cruise control.
When it comes to finances, we tend to rely on our slow brain for major moves (like refinancing your mortgage) and the fast brain for routine expenses (like gas, groceries, clothes, and pet supplies). And while that intuitively makes sense since you want to exert more energy and focus for big decisions, it can also be a problem because those nondescript everyday purchases can add up to a lot of money over time.
Your fast brain uses so much less energy because it makes rapid-fire associations comparing what you’re doing now with what you’ve done in the past. If you overspend at the grocery store, your brain will send fewer warning signals if you do it again next week, and even less so the time after that.
The good news is that if you start making small changes, your fast brain will adjust its comparisons and integrate some aspects of slow brain thinking. Things like using apps and other tools to track everyday spending, deliberately taking a set amount of cash with you when going shopping, not over relying on credit, and creating short-term financial goals are just some ways that can reset fast brain thinking to be more conscious and deliberate.
Just like how your fast brain uses your recent actions to make quick associations, anchoring is a way for your brain to use external information as a reference point for estimating value. The issue is that your anchoring bias is highly susceptible, and can be manipulated by irrelevant factors, like marketing tactics.
When a store is having a sale, it’s a common strategy to show the original price next to the sales price. The original price becomes an anchor so that the sale feels like a comparatively good deal. The purchase then becomes judged in relation to the discount, rather than the actual cost or value of the product itself.
However, it’s not just price tags that create bias as stores use other visual anchors to increase sales. For example, a field study advertised Cambell’s soup at 79 cents per can with a ‘limit 12 per customer” sign. Shoppers who bought from a display with no limit purchased an average of 3.3 cans. However, buyers who bought from a display with a limit purchased an average of 7 cans. The brain unconsciously anchors with the number 12 and adjusts, resulting in overspending.
Anchors are difficult to ignore because you honestly don’t even notice their influence. Even being aware of how restaurants, stores and advertisers use anchors doesn’t necessarily make it easier to avoid.
A good way to combat these tactics is to create your own anchors with something you love and frequently purchase, like your morning coffee. When shopping, think of everything in terms of coffee rather than dollars. That $30 shirt may seem like a good deal, but two weeks’ worth of morning coffee may be more than you want to spend. It creates a level of consciousness about spending trade-offs – would you rather the shirt, or the coffee? By creating your own anchor, you can more effectively prioritize your spending.
Look over there!
Shopping is a constant exercise in self-control, especially if you are trying to stick to a budget. Self-control requires willpower, focus, and mental energy – all things that waiver in the face of distractions. Even something as simple as texting or browsing social media when shopping has shown to increase the tendency to impulse buy.
These minor distractions don’t only lead to you overspending on small purchases while grabbing a coffee or grocery shopping, but on bigger purchases too. There is always a new gadget, or a great sale going on, and it’s far too easy to shop until you’ve spent all your extra cash…and then some.
To try and limit impulse shopping, wait 24 hours before purchasing anything over a certain limit, like $100.
Once you get past the initial rush of excitement, usually one of two things happens. Either your enthusiasm will wane, and you’ll rethink the purchase, or your continued excitement will encourage you to research the item and (hopefully!) compare prices. This approach may seem hard at first, but over time you will retrain your brain to think of items at a certain price with your slow brain (remember that?) instead of your fast brain.
Live for tomorrow, today
If someone offered you $50 today or $100 tomorrow, which would you take? Most people would choose to wait until tomorrow. After all, it’s not that far away! However, if someone offered you $50 today, or $100 a year from now, chances are you may rethink your answer. The further away the $100 is, the less important that $50 difference becomes.
Present bias or hyperbolic discounting is the tendency for humans to value smaller short-term rewards over larger, long-term rewards. People value immediacy over the higher value of money. The fact is, a lot can happen in a year, and the risk of getting nothing outweighs the chance of getting more money.
This bias is why planning for retirement or other long-term goals can be so difficult.
It’s easy to take money out of long-term savings for things we want now. Our present is much easier to picture than our future, and so we choose to get what we want when we want it. That said, if both events happen in the future, then most people will wait longer for the larger reward. For example, if you were offered $50 in 6 months or $100 in 9, you’d probably wait the extra 3 months.
People always think they are going to do better later! I’ll start my diet on Monday, I won’t work so late next week, I’ll save more next month. Humans are naturally optimistic about the future, so you should use that to set yourself up for success.
One relevant study had several companies ask their employees to invest a portion of their next raise into long-term savings, instead of the usual practice of asking for more to come out of their current paycheck. After following the companies through 4 annual raises, the study found that 80% of people remained in the plan, and average savings rates increased from 3.5% to 13.6%!
You can apply these principles to your own finances. Have an annual bonus? Pre-automate a transfer of the funds into investments or retirement savings on the appropriate date. Speak to your financial advisor or institution about ways you can use a cash flow plan to pre-automate future savings.
Going all in
All-in behaviour is when a purchase involves costs that seem unrelated, but actually drive up the price.
The simplest example of this is the disclaimer batteries not included. When thinking about how much something costs, you don’t associate the price of batteries with the price of the item, even though it does affect it. Batteries are a simple low-cost example, however this phenomenon is part of all kinds of purchases. For example, gift wrap for presents, lightbulbs and door locks for your new smart home device or larger expenses like upgrades on your new construction home.
When mentally tracking your spending, these add-ons won’t be associated with the cost of the original item, which creates a blind spot. You may not even remember that you purchased them! This blind spot causes you to overspend while simultaneously making you feel good about the purchase due to the additional costs making it better (e.g. home upgrades, gift wrap, etc.) or functional (e.g batteries, smart light bulbs, etc.).
All-in behaviour can be a hard nut to crack since getting the extras might seem unavoidable. Sometimes simply being aware of this blind spot can make all the difference. When buying something, take a moment to consider what might not be included in the price. If buying furniture, are you including the delivery fee and warranty in your mental calculation? If buying a new guitar, are you including the tuner, pics and guitar stand in the price? During the holidays, don’t forget to add up the wrapping paper and bows! Don’t get disheartened when you notice costs start to creep up. Being aware of how much you are really spending feels better than being shocked at your credit card statement next month. You’ll probably also start to notice opportunities to save on some of these all-in items or postpone buying them for a while.
The bottom line
Managing your money sometimes takes more than simply counting out dollars and cents. If that was the case, you would never wonder where your money went! The biases above are just a handful of the different behavioural influences that can impact your spending habits. However, just because they influence your behaviour, doesn’t mean your finances aren’t ultimately in your control. Being aware of behavioural biases is one of the best ways to avoid them and there are lots of ways to counteract their influence! Take a look at what you can do to use the strategies above to your advantage. Automating bill payments and savings transfers, creating fun short-term goals to motivate you to save, and understanding your financial priorities are all ways you can take advantage of your natural instincts. The same biases that make overspending easy, can also help you form new habits.